A Trade for All Seasons

Lawrence McMillan, editor of the Option Strategist, discusses a seasonal late-October trade that has a nearly perfect track record.

Traditionally, this is one of the best seasonal trades to be found: the market rallies strongly between October 27th and November 2nd of each year, [so you should] buy "the market"-which we'll define as Standard & Poor's 500-at the close of trading on October 27th. Sell your position out at the close of trading on November 2nd.

If October 27th falls on a weekend, then buy at the close of trading on the Friday preceding that weekend. If November 2nd falls on a weekend, then sell at the close of trading on Monday following that weekend. That's it-the whole system in just a few sentences.

The system has a terrific track record, dating back to 1978, [and] has made money in 27 of the last 30 years. It is also true that the market rallies at the end of most months, but October is clearly the best of the months (although January is no slouch, either-but that is a system for another time). There are several reasons for October's success, but the primary one that this works so well is that, in many years, the market is in a serious decline as October begins. Many institutional investors dump their stocks at that time. Then, the market usually bottoms in mid- to late-October, and those same investors plow back in before the end of the month-which is the fiscal year end for many mutual funds and other institutions.

Except for 2001 (in which the sharp selloff and market bottom occurred in September), the system had been nearly perfect until last year. In several years, including just two years ago, in 2005, the gains were huge for the five-day holding period. Last year, however, as we approached the end of October, there had been no major decline.

Our conclusion was that [the trade] does not work well in years in which October is generally bullish. There have been 11 such years and 8 of them have underperformed the average trade (including the two losing years). Usually, a strong October results in a weak result for the Seasonal Trade. Obviously, the trade has been able to make money at times, even if October is bullish, but the odds are far better if there is a market decline into the middle of October.

Essentially, our strategy is going to be as follows: if October remains bullish, then we are only going to take a token position for the Seasonal Trade this year. However, if a sharp decline develops some time in the next two weeks, then we'll take a more aggressive position for the Seasonal Trade. (That happened after this piece was written, then the market rallied again-Editor.)